Real World Economics: Better choices would have fixed Social Security

Social Security is very popular with Americans, even if most don't understand very well how it operates.

It is not difficult to make such a social insurance program financially sustainable if the nation has a stable population, or one that grows at a steady rate. However, a big bulge in a population, like the 81 million baby boomers born from 1946 through 1964, has made things more difficult. The total U.S. population increased from 141 million to 192 million over this span.

It is possible to deal with such irregular growth, and the 1981 Greenspan Commission nearly did so. Set up by Ronald Reagan, the commission's charge was to deal with the retiring boomers almost 30 years before the generational event was even going to start.

But the commission erred by overestimating how fast wages would continue to grow and by underestimating how much of any increase in national income would go to households above the limit on earnings subject to FICA, which funds Social Security. But their projections were not bad ones, given the trends from 1945 to 1980 that their analysts used.

Their errors can be fixed with a combination of small benefit cuts and a modest increase in taxes, mostly by raising the amount of income subject to the tax. This would mean that past and future taxes levied for Social Security would be sufficient to pay promised benefits for at least the next 75 years, past the point where nearly all baby boomers will be dead.

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However, having a program that is financially sustainable in terms of government budget accounts is not the same as having one that resolves the underlying challenge posed by a population bubble like the baby boom.

Disregard money for a while. Any society has to produce physical goods and useful services to meet the needs and wants of its people. All other things being equal, the more active workers there are relative to the entire population, the easier it is to produce those things society needs.

With a stable population, or one growing at a constant rate, the ratio of workers to consumers is predictable and does not vary rapidly. But again, a demographic bubble like the baby boom is problematic.

From the mid-1960s to the early 1980s, when the boomers were entering the labor force, the number of workers per retiree was high. But now that they are retiring, each person in the work force will have to produce goods for more people. If they are unable to do this, there will be fewer goods and services available per person. Living standards will drop.

In this case, the key question is whose living standards will drop -- the retirees', the workers' or some combination of the two? That depends on what claim each group has on available goods and services. Put another way, who will have buying power?

A social security system that is on a fiscally stable basis ensures that beneficiaries will have money to spend. But if this money comes out of the taxes paid by those still working, an increase in spending power for seniors will be offset by a decrease for younger age cohorts.

Neither group need suffer any reduction in levels of living if productivity rises. Higher productivity means that each worker will produce more output. There will be enough for themselves and their families and enough for retirees. So the prudent response to the economic challenge of the baby boom would be to increase productivity.

Such increases can come from better, labor-saving technology. And they can come from more tools or equipment per worker. The first requires investment in research and development. The second requires investing in what economists call "physical capital," tools, machines, infrastructure and, in our contemporary economy, in software and information-processing capability. It also can come from education that gives workers greater skills.

Such increased investment requires resources that can come only by sacrificing some consumption. This is one of the oldest lessons in economics. Societies that save a lot tend to grow faster than ones that save little.

The retirement of baby boomers would not hurt anyone if our society had saved enough and invested enough while the boomers were still working. Unfortunately, we did not. Instead of having increased national savings while the boomers were in their prime earnings years, we had low and falling savings.

National savings is the sum of savings by households, by businesses and by government. The restructuring of Social Security suggested by the Greenspan Commission was meant to decrease household consumption and increase government savings.

Baby boomers would have to pay higher rates of Social Security taxes than before. This would mean less money to spend on consumption.

These increased revenues, well above what was necessary to pay ongoing benefits for 30 years, would temporarily be lent to the general federal Treasury. As long as we ran a balanced budget in these general Treasury accounts, the increased balances owed the Social Security "trust funds" would allow the national "debt held by the public" to decrease.

As these existing Treasury bonds were paid off, capital would be freed for private businesses to invest in new productive facilities and equipment. The net effect would be similar to higher savings by workers, i.e. less consumption on their part and more money available for "physical investment" that would increase productivity.

The key to the whole plan was that the general government should maintain a balanced budget, or nearly so. If the government, outside of Social Security, cut taxes or increased spending, there would be no net savings by the public sector. And if cuts in income taxes offset increases in FICA taxes, there would be no decline in household consumption.

If we cut taxes, increased spending, and ran up the national debt owed to the "public," whether that public be U.S. mutual funds or the Bank of China, all would be for naught. Not only would we plant a time bomb under federal government finance, set to explode when the boomers retired, but we would stifle the increased investment in new productive machines, facilities and R&D needed to make it possible for the boomers' kids and grandkids to produce enough goods and services for everyone.

It was clear to economists, demographers and a few politicians what we needed to do. But it was not clear to many other elected officials, nor to the public. And so we did precisely what we should not have done. Under the banner of "deficits don't matter," we cut non-FICA taxes and increased government spending, while household savings simultaneously fell to near zero. We will pay the price over the next 30 years and there is no longer any real solution. We had our chance, but we blew it.